Investing in China: How to tame the dragon

On June 2, Gavin Graham was leaning over his desk, reading the news, when he came across an article that jolted him straight. The piece was about the now infamous accusations levelled at Sino-Forest Corp. by Carson Block, a little-known short seller, who said the company was engaging in a massive fraud.

It took a few minutes for the news to sink in, but Graham, CEO of Toronto’s Graham Investment Strategy, says he was not surprised by the allegations. While Sino-Forest’s corporate head office is in Toronto, it’s actually a Chinese business that listed on the TSX through a reverse takeover. Graham had been following the cases of several Chinese companies that listed this way and had recently been accused of fraud.

“I wasn’t shocked to hear there was another one,” he says. “I was surprised that the alleged deception had been going for so long.”

Graham wasn’t alone. Although the allegations have yet to be proven in court, in the investing public’s mind something was clearly amiss. Two weeks after Block went public with his claims, the company’s stock was down 76%. A few weeks after that the Ontario Securities Commission halted trading and Sino-Forest’s CEO resigned. Now that this once mighty company — last April it was the largest forestry company on the TSX with a $6-billion market capitalization — has fallen, and with numerous accusations aimed at other Chinese corporations, such as Toronto-listed Silvercorp Metals Inc., investors are wondering how they can buy into China’s growth story without getting burned.

Henry Zhang, San Francisco–based co-portfolio manager of Matthews International Capital Management’s China Fund, says to be wary of these reverse takeovers (RTOs). They occur when a foreign business buys a shell company that’s already listed on a North American exchange. It’s not just Chinese companies doing this, but 350 Chinese businesses have participated in RTOs since 2004. It’s often an easier and cheaper way to access Canadian and U.S. capital, and reporting rules are less onerous than for an initial public offering.

If a business buys a shell company on America’s over-the-counter bulletin board or Pink Sheets exchange—many of the recent RTO companies accused of fraud were on these markets—the reporting rules are almost non-existent. Zhang makes a point of staying away from these types of corporations.

“We frequently receive calls from the investor relations of reverse merger companies in the U.S.,” he says. “They want us to meet with management, and normally we don’t.”

Graham prefers purchasing companies that are listed on the Hong Kong Stock Exchange. “The question is, why would a Chinese company choose to come to North America?” he asks. “Hong Kong is a doorstep that has been used by world-class markets. It’s a perfectly well-functioning market.”

Frank Holmes, CEO and chief investment officer for San Antonio–based U.S. Global Investors, adds that penalties for fraud in Hong Kong and China are harsher than in North America. “The one thing about Shanghai is that you don’t want to be listed over there and have a scandal,” he says.

Wherever the company is listed, Mark Kopinski, chief investment officer at Kansas City’s American Century Investments, makes sure that the business he buys has been around for at least five years. Management should also have extensive experience running companies, he says. Holmes makes sure the CEO is well known in the capital markets. The idea is to purchase corporations that have a clean track record. Also look for companies that use reputable accounting firms. While that doesn’t mean numbers can’t be fudged, it’s better to have one of the major multinational firms looking at the books than an unknown Chinese accountant.

If you’re reading analysts’ reports, make sure the authors actually met with management. “If you can look someone square in the face, you can get a gut feeling whether the person is honest or not,” says Kopinski. If they talked to middle managers, suppliers and competitors, that’s even better.

Buying a good company in China isn’t that different from buying a strong business in Canada. Just like you would here, Graham says, buy blue-chip companies that pay a dividend. An earnings payout is something tangible. But, make sure the dividend is increasing year after year — that signals profits are rising and management is willing to share, says Graham — and that no more than 50% of earnings are being paid out. Any more and there’s a risk that the payment could be cut. Check that the money is coming from free cash flow and not from a bank loan, Holmes adds.

Unlike in Canada, though, buying a large-cap stock will still get you growth. China’s GDP is expected to grow by 10% in 2011, and with a rapidly expanding middle class there’s a higher chance your Chinese equities will outperform their Canadian counterparts long-term. Some investors want even faster growth. But buying small-cap Chinese stocks is extremely risky, says Graham. Because of China’s fast growth, problems containing inflation and Chinese investors’ relative lack of sophistication the market is already volatile.

“I don’t know why you would double on that risk by buying small companies,” he says. “You don’t need to be aggressive to get good returns in emerging markets.” Ultimately, investors should look for a clean balance sheet, which includes low debt and a manageable amount of receivables. Other ratios such as price-to-earnings and price-to-book are also important, but Kopinski says investors should approach these metrics the same way as they would with a North American company.

Sticking to sectors that sell into China’s domestic market is also a safe bet, but only purchase companies in industries you understand. For Kopinski, that means avoiding the country’s food industry. Regulations are lax, and China has a history of responding poorly to scares. He prefers buying department stores or makers of “hard products” such as TVs and cars — “things that I can get a good feel for and understand the market locally and globally,” he explains. Graham likes the mobile and brewing industries, while Zhang’s overweight in consumer staples, consumer discretionary and information technology.

While some of the country’s companies have lately been accused of fraud, Zhang points out that Chinese businesses are still good investments. He says about 450 China-based companies listed in Hong Kong or the U.S. last year alone, so the percentage of bad seeds is small. The country is also cheap today. The MSCI China index is trading at about 8.2 times earnings, compared to 12.8 for the S&P 500 and 15.6 for the S&P/TSX composite.

The lower valuation reflects investors’ uncertainty about the global economy and worries about inflation. Also, investors should be aware that both the Hong Kong and the Shanghai Stock Exchange experience more volatility than the TSX or NYSE. Chinese investors’ limited experience with stock markets, and attention to rumours and momentum over fundamentals, can often cause big swings. Investors need to be able to stomach the short-term volatility, says Zhang, but the long-term growth prospects will pay off.

Top picks

Intime Department Store Co. (HKG: 1833)

• This Shanghai-based holding company owns almost 900,000 square metres of floor space across 23 department stores. It’s actually one of China’s smaller department store companies, says Mark Kopinski of American Century Investments, but it’s expanding. It recently bought into three other chains, and its exposure to the country’s expanding middle class will see growth continue long-term. “We’re now starting to see earnings grow very rapidly,” he says.

Focus Media Holding Ltd. (NASDAQ: FMCN)

• Another one of Kopinski’s favorites, Shanghai’s Focus Media owns digital media, such as LCD billboards and elevator displays. Like most of the country’s best bets, it targets China’s growing consumer population. While the company has many local Chinese clients, it also has an increasing stable of multinationals that want to target the high-end customer. Its share price has climbed 26% since Jan. 1.

Brilliance China Automotive Holding Ltd. (HKG: 1114)

• If there’s one sector to be in, it’s the automotive industry, says Kopinski. Chinese consumers are hungry for vehicles, and the demand is just ramping up. Brilliance China manufactures BMWs for the Chinese market, and while Kopinski says it’s profitable now, the launch of the 5-series and 3-series cars “will help them tremendously.” The stock price has climbed 37% year-to-date.

Zhejiang Expressway Co. Ltd. (HKG: 0576)

• This Hong Kong–based business is yet another play on the country’s demand for cars. The company builds and operates high-grade roads and manages the tolls, advertising, restaurants and gas stations along them. The more people drive, the more people will use the highways, sending profits upward. “It’s a company that has demonstrated real business [sense],” says fund manager Gavin Graham.

iShares FTSE/Xinhua China 25 Index (NYSE: FXI)

• For those who don’t want to take the chance buying individual Chinese stocks, there’s always the FXI exchange-traded funds, one of the most heavily traded China funds. It holds only 25 stocks, but many of the names are blue-chip companies such as China Mobile, China Telecom and China Construction Bank. The downside could be its 49% weighting in financials, but because most banks are state-controlled, Graham says the government will likely step in if something goes wrong.

• This story was originally published on Canadian Business.